Why China cannot have a ‘Lehman moment’

Why China cannot have a ‘Lehman moment’

By Derek Scissors, published in the South China Morning Post

People are going to be discussing the flaws of Chinese finance for many years. Here’s a helpful guide: as soon as you see or hear “China’s Lehman moment” used seriously, stop paying attention.

China cannot have a Lehman moment. Its financial system does not work the way America’s (or Japan’s or Italy’s) does. In fact, it is not clear how China can suffer any sort of acute financial crisis. And it is extremely unlikely that, if such a crisis did occur, it would do lasting harm to the global financial system.

It is certainly true that Chinese finance has serious problems. The durable ones stem from dominant public ownership and the non-commercial behaviour it causes.

Deviating from commercial principles in finance promotes waste, starting with rolling over loans so state firms do not go out of business. Beijing covers up the waste by reporting levels of non-performing assets no one should believe.

The harmful incentives will hardly be reversed by the Communist Party’s promise to establish all of five private banks this year. These will be completely outmatched by state giants boasting tens of thousands of branches each.

Most short-term problems have been caused by the party’s decision to reverse a decade of slow financial reform and order banks to flood the economy with credit in 2009. The 32 per cent, 9.62 trillion yuan (HK$12.2 trillion) explosion in lending that year was arguably the biggest single attempt at stimulus in world history. It tied banks even more strongly to firms that should have gone bankrupt, and drove property prices sky high, as funds were diverted into speculation. Most broadly, the loan surge created a surplus of liquidity that will take years to work off, even assuming there is a sustained effort to do so.

The past year has seen occasional actions by the People’s Bank of China to constrain liquidity, each provoking near-panic in some quarters at the thought of China actually having normal interest rates. The financial system is weak: maturity mismatches and other indications of financial stress will continue indefinitely. But these problems are chronic, not acute.

The advantage of a non-commercial financial system is that it is hard for crises to materialise. Take the notion of a Lehman moment. What happened in the United States in late summer 2008 was a credit freeze. It was brought on by the inability of market participants to be assured of each other’s solvency in the face of complex liabilities that were difficult to evaluate.

The operative term here is “counterparty risk”, the fear that one party to a transaction cannot rely on another party to fulfil its contractual obligations.

The Chinese banking system is dominated by the state and a handful of state-owned insurers that generate 80 per cent of the industry’s premium income. The much-hyped “shadow banking” is mostly funded by assets moved off the balance sheet of state-backed financial firms to avoid regulatory scrutiny, or is lending by non-financial state enterprises that tap state banks, then relend. Local government debt accumulation reflects trillions of yuan in wasted funds and may even signal a failed development model. But it consists of one kind of state entity – local government financing vehicles – borrowing from other kinds of state entities and is more like a fiscal transfer than a true credit market transaction. Chinese financial firms are largely owned by the same entity and run by a small set of people moved around in their posts by the party. They go bankrupt only very rarely and under very tightly controlled conditions. The result of all this: no counterparty risk.

Here’s the proof. In what was perceived to be an emergency situation five years ago, Chinese banks established beyond any doubt their willingness to set aside commercial considerations and obey political directives, lending much more as corporate profits plummeted. US President Barack Obama bemoaned the unwillingness of American banks to lend during the crisis in 2009; Chinese President Xi Jinping has no such problem.

An uncharitable characterisation is that the situation of disingenuous accounting and insolvency fears among American, European, and other rich-economy financials in 2008 is the normal operating environment for their Chinese counterparts. There is no chance of a Chinese credit freeze lasting longer than a few days, because orders to lend would come down from on high.

What about other sharp financial shocks, such as a conventional bank run? A commercial banking system is only as strong as its weakest link, with a single troubled bank potentially triggering a string of failures. A non-commercial system ultimately controlled by the state may be stunningly inefficient but is probably only as weak as its strongest link, since the most solvent institution can simply be commanded to absorb losses elsewhere. It is quite easy to imagine the financial system progressively weighing down the economy over time with wasted money and unpaid debt. It is difficult to imagine any acute shock.

The last piece of the puzzle is how the Lehman failure led to a global financial crunch. China may be far more integrated into global finance than it was 20 years ago, but it is far less integrated than is the United States. The money of ordinary citizens cannot easily flow out, providing another check on internal instability. Equally important, global financials are still kept at arm’s length, limited in their bond, stock, and other investments. Even if a major Chinese entity did default on most of its obligations, the ripple effect across the globe would be very small.

Worry as much as you want about Chinese finance, but do not worry about a Lehman moment.